This invention relates generally to convertible and exchangeable financial instruments (e.g., debt instruments, preferred instruments, trust preferred instruments, warrants, certain insurance contracts, and suitable derivatives thereof, or any security backed by any of the above) and methods and systems for offering and servicing the same, and relates more particularly to debt instruments which are convertible into equity instruments.
A common financial instrument is a bond. A bond (more generally termed a “debt instrument”) is an instrument having language indicative of a principal amount, and having further language indicative of a borrower's obligation to repay the principal at some future time. Some bonds have still more language indicative of the borrower's obligation to make interest payments at specified times. Other bonds, called “zero-coupon” bonds, do not have language obligating the borrower to make interest payments in cash prior to maturity. Bonds, and the borrowing accomplished by means of such bonds, have been known for centuries.
Many financial instruments, including many bonds, are “negotiable,” meaning that the holder may freely sell the instruments to others with few if any restrictions. Such negotiability helps to provide a fluid and efficient market in which the instruments may be bought and sold at ever-changing prices indicative of the value given by the market to the instruments. A would-be borrower benefits from negotiability in many ways, for example because a lender is more willing to lend (to purchase the debt instruments) if it knows there is the prospect of selling the debt instruments to others at a later time. Negotiable bonds, and the borrowing accomplished therewith, have been known for over a century. Under the tax law of at least one country, the issuer of a bond may deduct from its income the interest paid (the “coupon”) or the stated yield for the bond.
Many business entities will have the ability to raise money by means of a mix of debt instruments (e.g. bonds) and equity instruments (e.g. stock). The mix selected by a particular business entity (often termed its “capital structure”) will be influenced in a general way by prevailing interest rates, as well as by other factors such as the extent to which the market at a particular moment is willing to purchase newly issued instruments of one type or the other. Further, a particular business entity will have particular business circumstances which influence this mix, such as the amount of debt already outstanding, the entity's bond credit rating, and the price-to-earnings (P/E) ratio for the entity's stock. Because the entity's financial condition (particularly for publicly held entities) is reported according to generally accepted accounting principles, the effect on the reported financial condition of a particular change to this mix is often an important factor influencing this mix. Finally, the tax treatment of a particular change to this mix is also often an important factor influencing such decisions.
One example of a convertible security, such as those which are termed “convertible bonds,” are instruments which have some of the qualities of bonds as well as some of the qualities of stock. A convertible bond is a bond which can be converted by its holder into a number of shares of equity, the number being a fixed number or being determined by a formula. It is thus possible to define a “conversion ratio” which is the number of shares of common stock that could be obtained by converting each share of the convertible instrument. In many instruments the conversion ratio is a constant over the term of the instrument, though in some instruments there may be a provision that the conversion ratio will change over the term of the instrument. Alternatively, the instrument may state a“conversion price” per share. With such an instrument the conversion price is divided into the par value of the bond to determine the number of shares available in the conversion. The instrument may contain a provision that this ratio may change over time.
At issuance, the value of the bond is typically greater than the value of the fixed number of shares into which the bond is convertible. For example, a bond may be issued for $1,000 with a right to convert into ten shares of the issuer's common stock, at a time when the current market value per share is $83. Ordinarily, under these terms, the stock would have to appreciate to at least $100 per share before it would be economically rational for the holder to exercise its right to convert the bond. A convertible bond of this kind is described as having a roughly 20-percent conversion premium, because the stock must appreciate about 20 percent (i.e. $17) before the conversion right has intrinsic value. This conversion premium may be thought of as the dollar or percentage amount by which the price of the convertible instrument exceeds the current market value of the common stock into which it could be converted. It is thus possible to define a “conversion value” which is the value of a convertible security if it is converted immediately.
Some convertible bonds also provide that the issuer may call the instrument (repay it before the end of the term of the bond) after a number of years, subject to the holder's conversion rights. If at the time of the call the value of the stock has risen above the value of the debt, the holder generally will choose to exercise its conversion right so that it receives the stock rather than the call redemption amount. A holder may also have the right to require an issuer to redeem the bond under specified circumstances.
It is instructive, then, to compare a bond that is convertible, and a bond that is not, from the point of view of the would-be purchaser (the investor) and from the point of view of the issuer. Because the conversion right provides an investor with a possible upside (related to the possible appreciation of the stock price) that the fixed-rate debt of the issuer would not provide, the interest rate on convertible instruments may be lower than the interest rate on fixed-rate instruments. Stated differently, the conversion right may be thought of as an option to acquire issuer stock, and the lower rate of interest compensates the issuer for providing this option. It is thus possible to define a “premium over bond value” which is the positive difference between the market price of a convertible bond and the price at which that bond would sell without the convertibility feature.
Stated another way, in the example of the convertible bond, because the conversion right provides an investor with a possible upside that a fixed rate debt instrument of the issuer would not provide, the interest rate on a convertible bond is lower than the interest rate on a fixed rate debt instrument. Economically, the conversion right is an option to acquire issuer stock, and the lower rate of interest compensates the issuer for providing this option. Convertible bonds have historically provided issuers of such convertible instruments with the ability to deduct for tax purposes only this lower stated amount of interest, which is often considerably below the true economic cost of the financial instrument.
Under the law of at least one country, the holder of a debt instrument with contingency provisions may be required to recognize interest income not at the actual coupon or the actual stated yield, but instead at the rate at which the issuer could have issued a debt instrument that did not have such a contingency and with a maturity and other terms otherwise comparable to the contingent debt instrument. This would generally permit the issuer of the instrument to deduct from its income (for tax purposes) the same amounts as the income accrued to the holder. Under such tax law, however, there is an exception for convertible debt instruments where the only contingency is conversion, and under this exception the issuer is only able to take deductions at the lower stated yield on the bond. This is undesirable from the tax point of view for the issuer.
It is instructive, then, to compare a convertible bond that has contingent payments, and a convertible bond without contingent payments, from the point of view of the would-be purchaser (the investor) and from the point of view of the issuer.
Issuers prefer to have flexibility and control over their capital structure, including, for example, the time and manner in which a convertible financial instrument is settled. That flexibility and control is diminished when a holder exercises its conversion or redemption right before maturity and at a time that is unrelated to an issuer's call of the financial instrument. From the issuer's point of view it would be desirable, therefore, to provide convertible financial instruments, and methods and systems for offering and servicing the same, which provide incentives to holders to refrain from voluntarily converting or redeeming such instruments, so that issuers maintain greater flexibility and control over the maturity date of the instrument and the manner in which it is settled.
Issuers also prefer to deduct an amount for tax purposes that more closely approximates the true economic cost of the financial instrument. As mentioned above, the tax law can limit an issuer's ability to deduct the true economic cost of a financial instrument under certain circumstances. It would be desirable, therefore, to provide convertible financial instruments, and methods and systems for offering and servicing the same, that provide issuers with the ability to deduct an amount for tax purposes that more closely approximates the true economic cost of the financial instrument.
A further problem can arise for would-be purchasers of debt instruments. A would-be purchaser (or an underwriter in a position to underwrite issuance of such instruments) may find that potential issuers of such instruments are not easy to find. It is then extremely desirable if the underwriter is able to devise some significant and nontrivial variant on the prior-art debt instruments, which variant is somehow of interest to potential issuers when prior-art debt instruments would not be of interest.
One known bond was a particular zero-coupon convertible bond, convertible to stock. With this particular bond, a payment was made to the holder under certain circumstances. For example, if the stock price happened to be above a scheduled level, the bond would pass through an amount equal to the dividends paid to the underlying shares. Stated differently, the issuer would pay to the holder an amount equal to the dividends paid with respect to shares of the type into which the bond could be converted. An objective of this payment provision was to deter conversion, that is, to motivate a holder to refrain from converting.
Another known bond of this general type also provided for payment to the holder in the event of an extraordinary dividend, meaning a case where the dividend was larger than the stock price the day before the dividend was paid. This particular bond, however, only permitted the issuer to deduct a lower stated amount of interest, which might be considerably below the true economic cost of the instrument.
This particular bond also provided that the ratio (the number of shares into which the bond could be converted) would be recalculated in the event the dividend was greater than 12 ½ percent of the stock price in a six-month period, or greater than 25 percent of the stock price in a twelve-month period. The new ratio was the old ratio times the stock price prior to the dividend, divided by the stock price prior to the dividend plus the dividend.
Much effort has thus been expended in recent years to attempt to devise new and different debt instruments, and particularly, new and different convertible debt instruments, which offer advantages over those in the prior art. These efforts necessarily entail devising methods and systems for offering and servicing such financial instruments. It is noted in passing that U.S. Pat. No. 5,062,666 to Mowry et al. has claims directed to a financial instrument per se. That particular financial instrument is not, apparently, directed toward the problems described herein.
Experience shows, however, that the majority of such efforts are unavailing. In some markets, for example, it may be extremely difficult to devise an instrument which somehow works sufficiently to the advantage of both issuer and purchaser to make possible the issuance of the instrument.
If it were possible to devise a convertible debt instrument, or a family of convertible debt instruments, which through their provisions somehow bring about successful market transactions that would otherwise not be possible, this would work to the advantage of issuers and investors. It would, furthermore, make a meaningful contribution toward a more vigorous, more active, and more efficient capital market, thus benefitting the general public as well as particular market participants.